Bid-Ask Spreads: Measuring Trade Execution Costs in Financial Markets

Bid-Ask spreads, which measure trade execution costs, and reflect the price concessions necessary to complete transactions quickly, are important as indicators of market quality and in determining traders’ actual investment results. Execution costs arise because it is costly to provide liquidity, and can be estimated based on comparisons of trade prices to proxies for underlying security value, with the most common proxy being the quote midpoint.

It focuses on three related measures of trading costs: quoted spreads, effective spreads, and realized spreads.

Methods and Subjects

Main Result

Research indicates that differences in execution quality across markets are related to both exchange-design features, such as tick size and order handling rules, and the regulatory environment, such as the enforcement of insider trading laws and the protection of shareholder rights

Conclusion

The amount of asymmetric information present in a market can be estimated by assessing trades’ price impact, measured as the difference between post and pre-trade estimates of security value.